International Economics notes

Notes International EconomicsPART 1 – INTERNATIONAL TRADE Lecture 1 – General introduction on world trade flows (Ch.2) The Gravity model (Tinbergen) gives an estimation of the size of trade between two countries. Tij = (Yi)a x (Yj)b / (Dij)c Tij = vale of trade between country i and j. Yi = GDP of country i Yj = GDP of country j Dij = trade impediments between country i and j. a,b,c = values that measure importance of size and trade impediments. ln(Tij) = a x ln(Yi) + b x ln(Yj) – c x ln(Dij) + ϵij The Gravity model shows that size matters: 1. Larger economies produce more goods and services, so they have more to sell in the export market. 2. Larger economies generate more income from the goods and services they sell, so they are able to buy more imports. Trade impediments - Distance between markets influences transportation costs and therefore the costs of import and export. - Cultural affinity: If countries have cultural ties, it is likely that they also have stronger economic ties. - Geography: Ocean harbors, easily navigable rivers, lack of mountain barriers influence the ease of international transportation. - Borders: Crossing borders involves formalities that take time and can involve monetary costs like tariffs. These implicit and explicit costs reduce trade. Trade agreements increase trade between specific areas. Globalization - The negative effect of distance has becomes smaller over time, but it is still significant. The world is not ‘flat’. A country’s location on the globe is still very relevant for determining the ease of access to markets. - Political factors play an important role (wars, free trade negotiations, China opening its markets etc.) Changing composition of trade Today: 55% manufactured goods, 20% services, 18% mineral resources, and 7% agricultural goods. 1 Past: (VOC/Dutch East-India Company) mostly agricultural and mineral resources. This change in composition does not only hold for developed, high-income countries. Apart from some exceptions, middle- and low-income countries also trade mostly manufactured goods. Important recent developments 1. Trade in intermediate goods, more complex international supply chains  increases countries’ dependency. 2. Trade in services, more outsourcing because of advanced modern communication technology. Service outsourcing (or offshoring) occurs when a firm providing services moves its operations to a foreign location. Service outsourcing can occur for services that can be performed and transmitted electronically. Trade in services is not a significant part of the world trade (20%), but its share is increasing. Some services are non-tradable, but more jobs will become outsourceable. Increased internationalization of production networks enables countries to specialize and increases the efficiency of production processes. However, it also increases the vulnerability of production processes  companies diversify their intermediate production to different countries. Summary - World trade is larger than ever, largest share of trade takes place between developed nations, but developing world is catching up. - The gravity model predicts that the volume of trade is directly related to the economic size of each trading partner and the trade impediments between them. - Important examples of trade impediments are distance (transport costs), culture, geography, the existence of borders, free trade agreements. - Modern transportation and communication have increased trade, but political factors have historically had a much larger influence on trade. - Today, most trade is in manufactured goods, while historically agricultural and mineral products made up most of trade. - Also, trade in intermediate goods now makes up the largest share of world trade: - increased complexity of supply chains - increased international dependency in production - In the future, trade in services is likely to become a much more important component of world trade. Lecture 2 – The Ricardian Model (1) (Ch.3) Theories of trade: 1. Models emphasizing differences between countries as the main driver of trade. Difference in labor skills, natural resources, physical, and technological create productive advantages for countries. 2. Models emphasizing economies of scale. No prior differences between countries, but more efficient if each country specializes in a (few) products only, benefitting from economies of scale. 2 To understand the causes and effects of trade it’s useful to look at models that focus on one particular motive for trade separately. Ricardian model Trade arises because of differences in relative labor productivity between countries. Opportunity costs: the costs of not being able to produce something because resources have already been used to produce something else. Comparative advantage: A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in that country than in other countries. Gains from trade: More goods and services can be produced and consumed compared to the situation where each country makes all goods and services itself. Assumptions 1. Labor is the only factor of production. 2. Labor productivity varies across countries due to differences in technology, but labor productivity in each country is constant. 3. The supply of labor in each country is constant. 4. Only two goods are important for production and consumption (wine and cheese). 5. Perfect competition between firms, free entry/exit of firms. 6. Perfect labor mobility between sectors. 7. The world consists of two countries: Home and Foreign. 8. No transportation costs. Production possibilities depend on the amount of labor available and unit labor requirement. (High unit labor requirement = low productivity). L = total number of hours worked (constant by assumption) QC = how many pounds of cheese are produced QW = how many gallons of wine are produced aLC = the unit labor requirement for cheese aLW is the unit labor requirement for wine Production possibility frontier: aLCQC + aLWQW =< L In equilibrium: aLCQC + aLWQW = L The PPF shows the maximum amount of goods that can be produced using a fixed amount of resources. QW = L/aLW – (aLC/aLW) QC aLC/aLW = opportunity cost of producing and extra unit of cheese in terms of wine. (how much wine could be produced if one unit less of cheese would be produced?) wC = PC/aLC wW = PW/aLW If wC = PC/aLC > PW/aLW = wW, workers will only make cheese, and vice versa. Workers are only willing to make both wine and cheese if wC = wW  PC/aLC = PW/aLW  PC/PW = aLC/aLW Two countries, Home and Foreign Suppose Home has an absolute advantage: aLC < a*LC and aLW < a*LW 3 (less wine can be produced by reducing cheese production in home) Relative price reflects opportunity cost in each country. when the relative price of cheese equals the opportunity cost in the foreign country [aLC /aLW < PC /PW = a*LC /a*LW]: Foreign workers are indifferent about producing wine or cheese (wage when producing wine same as wage when producing cheese). World relative supply of cheese = quantity of cheese supplied by all countries relative to quantity of wine supplied by all countries: RS = (QC + Q*C)/(QW + Q*W) 1 If the relative price of cheese falls below the opportunity cost of cheese in BOTH countries [PC /PW < aLC /aLW < a*LC /a*LW] Nobody produces cheese: both foreign and domestic workers rather produce wine. where wages are higher. World relative supply of cheese equals Home’s maximum cheese production divided by Foreign’s maximum wine production RS = (L / aLC) / (L*/ a*LW) 4 . RS = 0 2 Similarly: if the relative price of cheese rises above the opportunity cost of cheese in BOTH countries [aLC /aLW < a*LC /a*LW < PC /PW] Everybody produces cheese: both foreign and domestic workers rather produce cheese. where wages are higher.Suppose Home has a comparative advantage in cheese production: aLC/aLW < a*LC/a*LW  lower opportunity cost of producing cheese in terms of wine. If there is no trade: PC/PW = aLC/aLW < a*LC/a*LW = P*C/P*W It will be profitable to ship cheese from Home to Foreign. 0 =< RS =< (L / aLC) / (L*/ a*LW) 4 Similarly. (L / aLC) / (L*/ a*LW) =< RS =< infinite 5 When the relative price of cheese settles strictly in between the opportunity costs of cheese [aLC /aLW < PC /PW < a*LC /a*LW] Domestic workers produce only cheese (where their wages are higher). Foreign workers produce only wine. and wine from Foreign to Home. Domestic workers produce only cheese. Foreign workers still produce only wine (where their wages are higher). RS = infinite 3 When the relative price of cheese equals the opportunity cost in the home country [PC /PW = aLC /aLW < a*LC /a*LW]: Domestic workers are indifferent about producing wine or cheese (wage when producing wine = wage when producing cheese). this is an incentive to trade. 3) Gains from trade? . or w/PW = PC /PW x 1/aLC wine 5 . QC + Q*C QW + Q *W Opening up to trade: PC/PW < PworldC/PworldW < P*C/P*W  each country specializes in producing the good in which they have a comparative advantage.Relative price of cheese. they earned w = PC / aLC . they earn w = PworldC / aLC . They can buy more wine with their cheese.Use the income generated from that production to buy the goods and services that it desires (some of which are produced abroad!) Domestic workers earn a higher (real) income from specializing in cheese production since the relative price of cheese increases with trade. this wage buys them: w/PworldC = 1/aLC cheese. Lecture 3 – The Ricardian Model (2) (CH. PC/PW 2  4 a*LC/a*LW 5  3 1  RS  aLC/aLW   L/aLC * * L /a LW Relative quantity of cheese. With trade. . or w/PworldW = PworldC /PworldW x 1/aLC wine Before trade. that wage bought them: w/PC = 1/aLC cheese.Each country specializes in the type of production which uses resources most efficiently. The home wage relative to the foreign wage will settle in between the ratio of how much better Home is at making cheese and how much better it is at making wine compared to Foreign.Low productivity can be offset by low wages. Relative supply in our model is fixed by the amount of labor in each of the countries: RS = L/L* Relative demand of domestic labor services falls when w/w* rises. . Total wage payments = total cost. How do wages in the two countries compare when they trade? Home: wC = PworldC / aLC Foreign: w*W = PworldW / aLw Relative wages: WC/W*W = (PworldC/PworldW) x (1/aLC) WC/W*W < a*LC/aLC 1.Their purchasing power remains the same in cheese and increases in wine (PC /PW < PworldC /PworldW). that wage bought them: w*/P*W = 1/a*LW wine. or w*/PworldC = PworldW /PworldC x 1/a*LW cheese Before trade.High wages can be offset by high productivity. they earn w* = PworldW / a*LW . Or equivalently. they earned w* = P*W / a*LW . Foreign workers earn a higher (real) income from specializing in wine production since for them the relative price of wine increases with trade: they can now buy more cheese with their wine. then the good will be produced in that country. 6 . Good i will be produced in the country where total wage payments to produce it are lowest. (a*LW /aLW ) < (wC / w*W) < (a*LC /aLC ) Productivity (technological) differences between countries determine relative wage differences across countries. Trade expands a country’s consumption possibilities beyond its own production possibilities. WC/W*W > a*LW/aLW 2. we need to know their productivity differences and their wages. 2. With trade. Comparative advantage with many goods N goods: i = 1. 3 … N Unit labor requirement: aLi and a*Li To determine which country has a competitive advantage in which type of production. These relationships imply that both countries have a cost advantage in production! . If waLi < w*a*Li then only Home will produce good i. or w*/P*C = P*W /P*C x 1/a*LW cheese Their purchasing power remains the same in wine and increases in cheese (P*C /P*W > PworldC /PworldW). if a*Li/aLi < w/w* if the relative productivity of a country in producing a good is higher than the relative wage. this wage buys them: w*/PworldW = 1/a*LW wine. and demand for these goods and the labor services to produce them falls. Trade benefits all countries because the relative price of the exported good rises: income for workers who produce exports rises. Output (Q) = area under the MPL-curve. goods produced in the domestic country become more expensive. 2. Lecture 4 – The Specific Factors Model (Ch. labor. diminishing marginal returns. Two goods (cars and food) 2.t. and land (T) 3. Labor is a mobile factor: it can move between sectors 7. and imported goods become less expensive. Food is produced using labor and land 5. although transportation costs and other factors prevent complete specialization in production. the relative price settles in between what the relative prices were in each country before trade.Resources can’t move immediately or costless from one industry to another.r.4) International trade has strong effects on the distribution of income within a country: . Specific factors model: Countries as a whole benefit from trade. MPL: marginal product of labor.Why?  Two effects 1. Differences in the productivity across countries generate comparative advantage. . Assumptions 1. As domestic labor services become more expensive relative to foreign labor services. With trade. LC) } Cobb-Douglas functions. 2. derivative of the production function w. Summary 1. Cars are produced using labor and capital 4. Perfect competition in both markets 6. One country QC = QC (K. Land and capital are specific factors: they can only be used in the production of food and cars respectively. capital (K). 6. MPL decreases QF = QF (K. A country has a comparative advantage in producing a good when its opportunity cost of producing that good is lower than in other countries. Fewer goods will be produced in the domestic country (because cheaper to produce elsewhere). .High productivity or low wages give countries a cost advantage. Empirical evidence supports trade based on comparative advantage. LF) } with the number of people already employed. The Ricardian model assumes these two away. further reducing the demand of domestic labor services. Three factors of production: labor (L). Countries export goods in which they have a comparative advantage.Industries differ in the factors of production they demand. 5. but it may hurt significant groups within the country. 3. L = LC + LF 7 . 4. wC = MPLC x PC wF = MPLF x PF 8 . and allocation Labor supply: L Labor demand: profit-maximizing number of workers.MPLF / MPLC The opportunity cost rises with the amount of the good already employed: diminishing returns to labor. wages. With more capital provided the MPL increases -> wages as well. Prices.Production possibilities frontier: Slope of PPF: opportunity costs of cars in terms of food = . Capital owners are better off 1. Trade in the Specific Factors Model 9 . Price change 1. the MPLC will drop because more people now work in the cars sector. and the price of cars rises by 7% whereas wages only rise by less than 7%. The triangle from paralel points on both curves + eq point is how much world output increases! Equilibrium wage and allocation of labour where labor demand functions intersect. 2. 2. capital owners. Proportional change in prices. . However. so the relative wage in terms of food (PC/PF) rises. They earn more: output goes up. wF = wC  MPLF x PF = MPLC x PC  .And. . but because more people want to work in cars now.MPLF / MPLC = . In the Specific Factors model. 2. Also: they can buy less cars for a given amount of food they produce (relative price of cars has risen). a change in relative prices will . Suppose PC increases and PF stays the same  PC / PF increases.PC / PF.If cloth labor is under food labor curve. It is ambiguous whether workers are better or worse off. WC increases. WC = MPLC x PC.Welfare of workers. The wage also increases proportionately. Intuition: higher wages attract more workers. otherwise labor moves. A change in relative prices. and land owners changes. then workers migrate to food sector. There is no reallocation of labor and production. PF stays the same. Since the wages and the prices both increase with the same amount. . the real wage stays the same. The output (QC) will also increase. this attracts labor. employers can reduce wages a bit and still get enough people to do the job. The wage doesn’t increase as much as the price does. relative wage in terms of cars (PF/PC) falls.Allocation of labor between sectors changes. (move from f to c production) . 3. Land owners are worse off 1.Benefit the owners of the factor specific to the sector whose relative price increases. Wages go up 2. They earn less: output goes down.Hurt the owners of the factor specific to the sector whose relative price decreases. Also: they can buy more food for a given amount of cars they produce (relative price of cars has risen). However. and wages rise by 7% whereas the price of food remains unchanged. Relative price stays the same. the effect on the mobile factor is ambiguous. Workers 1. it depends on their preferences for food and cars. The part of the budget constraint that lies within the blue area.QF) = (PC / PF) x (QC – DC) Imports of food = relative price in terms of cars time exports of cars.Only trade if world relative prices are different from prevailing relative prices without trade. Trade changes prices. Suppose Home can produce more cars relatively cheaper and has more capital / worker available to produce cars. which increases the price of cars. because of different technologies and different resources. 2) Relative supply changes. For other parts of the budget constraint. other countries will demand cars. Owners of the other resource are hurt by it. When it opens to trade. As a result. firms in other countries can produce goods at higher or lower costs. is the part in which the country is definitely better off. the price of cars in Home are relatively low compared to Foreign’s prices. Labor abundant produces labor intensive good -> after trade relative price will increase in it. because 1) relative demand changes. Gains from trade With trade. the budget constraint looks like: PC x DC + PF x DF = PC x QC +PF x QF (DF . The relative price of cars (PC/PF) has increased. because people in other countries have different preferences. it is possible that the country is 10 . b.Benefits the owners of the factor specific to the sector whose relative price increases: the exporting sector . Factors specific to export sectors in each country gain from trade. International trade affects the distribution of income in the specific factors model a.Hurts the owners of the factor specific to the sector whose relative price decreases: the sector that faces toughest competition from imports . Trade always benefits the country as a whole. workers move costlessly between sectors .Opening to trade may lead to an increase in (short-run) unemployment Summary Trade and the Specific Factors Model 1. Budget constraint intersects the PPF at the chosen production point. Income distribution effects arise for two reasons: a. because it expands a country’s consumption choices. machines can be changed.However. Factors of production cannot move costlessly and quickly from one industry to another b. Trade strongly influences the income distribution within a country. while factors specific to import-competing sectors lose. In the real world this effect of trade may actually be smaller or larger Why smaller? . because it changes the relative prices.better off.Finding new jobs in the exporting sector may not be easy . Most economists would prefer to address the problem of income distribution directly.Opening to trade shifts jobs from import-competing to exporting sectors . in the real world this may not happen instantaneously .Effect on mobile factors is ambiguous It is possible to redistribute the income in such a way that the winners compensate the losers. Changes in an economy’s output mix have differential effects on the demand for different factors of production 3. Trade nonetheless produces overall gains in the sense that those who gain could in principle compensate those who lose while still remaining better off than before 5. but that depends on the preferences. International trade often has strong effects on the distribution of income within countries produces losers as well as winners 2. this is very hard to implement. Mobile factors that can work in either sector may either gain or lose 4.People can acquire new skills. .The specific factors cannot move to the other sector (completely immobile) In the real world this is usually not the case: .In the Specific Factors model. however. rather than by restricting trade 11 . land can be replanted or used to build a factory on => Heckscher-Ohlin model Why larger? . LF) Diminishing returns to labor and capital  Cobb-Douglas function. producers use less labor and more capital in the production of both food and cars. Same technology in the two countries. 4. At that point. Two countries: Home and Foreign. V* (given prices for the two goods). Given the prices. and land can be changed. but varies between countries.6. 7. Two factors of production: capital (K) and labor (L). Cars production is labor-intensive  LC/KC > LF/KF at any price level. QF = V*/PF – (PC/PF) x QC Slope = . Each factor of production can be used in each sector. people can acquire different skills. Especially in the long run. Lecture 5 . Assumptions 1. 12 . 6. A low MPL  high opportunity cost. If PC/PF < opportunity cost of cars in terms of food: produce less cars. Perfect competition in both sectors. causing trade restrictions to be adopted that are far from “optimal”. LC) and QF = QF(KF. 8. which equals the opportunity cost. 3. 2. Cars production is labor-intensive and food production is capital-intensive. but also on the wage (w) and the rental rate (r). The slope of the PPF = opportunity cost of cars in terms of food. 5. because prices equal production costs in competitive markets. This is more realistic as most factors of production can be used to produce different goods. Those hurt by trade are often better organized than those who gain. If w/r increases. Two goods: cars (C) and food (F). Value of production: V = PC x QC + PF x Q= An isovalue line represents what combination of QC and QF result in the same constant value of production. PC/PF and w/r are directly related. the relative price equals the slope of the PPF. the economy produces at the point Q that touches the highest possible isovalue line. machines can be put to a different use.PC/PF If PC/PF > opportunity cost of cars in terms of food: produce more cars. The output does not only depend on prices. 5) The Heckscher-Ohlin Model focuses only on how differences in resources result in trade between countries.The Heckscher-Ohlin Model (1) (Ch. but there is no international mobility of production factors  rental rate (r) and wage (w) equalization between sectors. In the long run capital and labor can freely move across sectors. One country QC = QC(KC. Supply of labor and capital in each country is constant. PC /PF.  Relative goods prices affect input choices. some firms switch from producing food to producing cars. Real income of workers goes up and that of capital owners goes down. Relative factor prices affect input choices. Raise the real income (purchasing power) of workers and lower the real income of capital owners. is predicted to: 1. 13 . firms use relatively less labor and more capital than before. it is predicted to: 3. L/K decreases. Food production is capital-intensive and cars production is labor-intensive. used in both industries. therefore w/r will increase. 2. . If PC/PF increases. L/K. (But… increase the amount of both labor and capital used in car production) Moreover. Raise (real) income of workers relative to that of capital owners. Stolper-Samuelson theorem: If the relative price of a good increases.Relative goods prices affect relative factor prices.The real wage or rental rate of the other factor decreases.The real wage or rental rate of the factor used intensively in the production of that good increases. w = PC x MPLC r = PC x MPKC w/PC = MPLC r/PC = MPKC Since in both sectors. An increase in the relative price of cars. we know that MPL increases in both sectors and MPK decreases. Lower the ratio of labor services to capital. Any change in the relative price alters the distribution of income. There will be excess supply of capital and excess demand of labor. w/r (note: they pay the same prices). In both sectors. then . Overall cars output rises and food output falls. two products (cars and food). If a good’s relative price goes up (at given factor endowments): • Relative factor price (wage or rent) of the factor used intensively in the production of that good goes up • Firms in both sectors use relatively less of that factor • Real income of that factor increases.Foreign’s food is relatively cheap for Home consumers. RS-curves are NOT the same. Except: . Initially RD and RS in each country determine how much of each good is produced and at which prices. then the supply of the good that uses this factor intensively increases and the supply of the other good decreases.Foreign (*) is capital-abundant (K/L < K*/L*) Abundance is always measured in relative terms.Input mix in both sectors (LC/KC and LF/KF) unchanged.Suppose L increases. Relative prices will converge: PC/PF < PworldC/PworldF < P*C/P*F 14 .5) Main results Heckscher-Ohlin model: 1.Home is labor-abundant (L/K > L*/K*) . RD-curves are equal in both countries. consumer preferences). Labor also moves to the cars sector.Home’s cars are relatively cheap for Foreign consumers. . Assumption: L/K and L*/K* are not too big or too small: both countries produce both goods. .w/r unchanged . LC/KC > LF/KF Capital moves from food to cars production: LC/K increases and KF/K decreases. (For the derivation see the lecture slides). and two factors of production (capital and labor). Lecture 6 – Heckscher-Ohlin Model (2) (Ch. However. whereas that of the other factor decreases 2. When opening up to trade . assuming countries are equal in all respects (production technology. two countries (Home and Foreign). The Heckscher-Ohlin model focuses on differences in resources endowments. but relative prices remain unchanged. Rybcszynski theorem: If you hold goods prices constant: as the amount of a factor of production increases. If a factor’s relative supply increases (at given goods prices): • Output of the good that uses that factor intensively increases • Output of the other good decreases Trade in the Heckscher-Ohlin Model A “2 by 2 by 2” model. Foreign increases its relative supply of food and exports some of its food to Home. Heckscher-Ohlin theorem: An economy is predicted to export goods that are intensive in its abundant factors of production and import goods that are intensive in its scarce factors of production. that uses a country’s abundant factor intensively. 15 . 2. Given identical technologies  production costs are the same in both countries. Perfect competition in both sectors implies that goods prices equal production costs. Factor price equalization: opening up to trade causes relative goods prices to converge in the two countries. The Heckscher-Ohlin model also predicts: 3. the relative price of that good rises. Home increases its relative supply of cars and exports some of its cars to Foreign.Trade makes relative prices converge! In each country. As a result: 1. Factor price equalization. all products are tradable. but there is no evidence for skills-scarce countries. it is possible to make everyone better off. 2. The trade between developed and developing countries.Overall gains from trade No trade: QF = DF and QC = DC With trade: country can consume more/less than what it produces by importing/exporting from other countries. 3. no trade costs. There is no evidence to support this. Owners of a country’s scarce factor are hurt by trade: their real income decreases. there is no policy for minimum wages. both countries produce both goods. Skill-biased technological change: technological change that increases skilled labor’s productivity more than unskilled labor. Empirical evidence Predictions: 1. The effect(s) of trade on income inequality. PCDC + PFDF = PCQC + PFQF (DF – QF) = (Pc/Pf) x (QC – DC) Quantity of imports = relative price of exports x quantity of exports Since the country as a whole always gains from trade. There is no good evidence in the United States. 16 . but it can only spend what it earns (budget constraint). This is because of the unrealistic assumptions: equal technologies. There is evidence in the Western world to support this. but it explains the pattern of North-South trade quite well. Pattern on trade. Without redistribution Owners of a country’s abundant factor gain from trade: their real income increases. Overall: The evidence to support the predictions made by the Heckscher-Ohlin model is weak. 17 . this has important consequences: • Each country exports the good that uses its abundant factor intensively • Goods price equalization results in factor price equalization across countries • Overall. However.6) The Standard Trade Model combines the ideas of the Ricardian. Relative prices differ. The Standard Trade Model can be used to look at those issues that do not necessarily require us to make further assumptions on why exactly countries differ in production possibilities. result in different relative goods prices. Assumptions 1. because production possibilities differ. Summary • When countries do not trade: • Their differences in relative factor abundance.  Firms will hire more skilled workers relative to unskilled workers. Increase in wages of skilled people more than that of unskilled people. by focusing only on • differences in resource endowments as a cause of trade it • abstracts from differences in technology (Ricardo) • In the real world: • trade happens BOTH because of differences in resources and differences in technology Lecture 7 – Standard Trade Model (CH. and Heckscher-Ohlin Model (all previous models are specials cases of the Standard trade Model). countries started trading when relative prices differed between countries. In the previous models. it can explain trade patterns between high income countries and low/middle income countries. • When countries start trading: Relative prices converge. The main explanation for this is that the Heckscher-Ohlin model does consider technological differences between countries. This is contrary to what is predicted by the Heckscher-Ohlin model. Two goods (cars and food). each country is better off with trade as it expands consumption possibilities • But. specific groups gain while other lose: • Owners of a country’s abundant factor gain • Owners of a country’s scarce factor lose • Winners could compensate losers while still being better off (… in theory) • Empirical evidence supporting HO-model is weak • Main reason for this appears to be that. Overall there is no conclusive evidence for neither the Heckscher-Ohlin model nor skills-biased technological change. Relative price of the good using a country’s abundant factor intensively is lower. Specific Factors. 4. Production possibilities frontier Maximize the value of output: V = PCQC + PFQF  QF = (V/PF) – (PC/PF) x QC The relative supply curve can be derived from PPF: if the relative price of a good increases. PCDC + PFDF = PCQC + PFQF Demand is determined by the relative prices of goods and consumer preferences (indifference curves). Production choices are determined by the economy’s PPF and the prices of output. Foreign is relatively more efficient in producing food compared to cars. Consumer preferences are the same in both countries. relative prices will adjust and will form an equilibrium where RD is tangent to the PPF.2. 3. Home is relatively more efficient in producing cars compared to food. What if consumption point (RD) is not on the PPF (RS)?  Equilibrium relative price If there is no trade. The value of an economy’s consumption must equal the value of an economy’s production. If there is trade: 18 . the relative supply also increases. Two countries (Home and Foreign). 5. It does not affect other countries’ growth. Because biased growth changes world relative prices. BUT it may also have an effect on the welfare of other countries. . because they are more expensive. Economic growth is usually biased: it occurs in one sector more than in others. consumers have relatively more to spend so they can in principle buy more of both goods. Change of welfare: 1. At given prices: biased economic growth increases the relative supply of the good produced by the sector towards which growth is biased. World relative supply of cars > supply of cars in Foreign. Biased growth changes a country’s PPF. Also: World relative supply of cars < supply of cars in Home. Caveat: A fall in a country’s Terms of trade will never decrease a country’s welfare level below that in absence of trade. With trade 1. Growth may have an additional effect on the welfare of the country in which the growth occurs. 2. 2. consumers in Home will buy relatively less cars than before. Substitution effect: Because PC/PF increases.World relative prices are determined by: . (prices of the sector decreases) Biased economic growth changes countries’ terms of trade (whether it happens at home or abroad). If the relative of price of cars in terms of food increases. No trade Growth is always good for a country.World RS (QC + Q*C) / (QF + Q*F) At a given relative price PC/PF: QC/QF > Q*C/Q*F (For the mathematical derivation. see the lecture slides). 19 . A decline in a country’s terms of trade decreases its welfare. Income effect: Income goes up. Terms of trade and welfare A country’s Terms of Trade = price of exports / price of imports A rise in a country’s terms of trade increases its welfare. Trades makes relative world prices converge! Opening up to trade allows consumers to consume a bundle of goods that could not be consumed in autarky that lies on a higher indifference curve = gains from trade. causing relative supply to change. It expands production = consumption possibilities.World RD (DC + D*C) / (DF + D*F)  the same in both countries. Export-biased growth worsens a country’s terms of trade and welfare. If the country is large enough. If growth happens at home: . Home’s welfare decreases and Foreign’s welfare increases. Unless the tariff or subsidy is the same in all sectors. 1 Suppose. . Therefore.If unbiased: no effect on welfare at home.If import-biased at home: it raises the positive welfare effect of growth itself.If import-biased abroad (= export-biased at home): it reduces welfare at home. The overall effect depends on whether growth happens at home or abroad. The Standard Trade Model predicts that: 20 . This changes relative supply and relative demand. The subsidy on cars in Home lowers the world relative price of cars  worsens in Home’s terms of trade and improves Foreign’s terms of trade. If growth happens abroad: . this improves their terms of trade and lowers Foreign’s terms of trade. . Thus it changes world relative prices. These changes will also be reflected in world relative demand and supply and thus relative world prices. .If unbiased: only positive effect of growth itself. . it changes relative prices in the country.If export-biased at home: it reduces the positive welfare effect of growth itself. Since Home exports cars. A subsidy on car exports in Home  increases the relative price of cars in Home  Relative supply of cars increases and relative demand of cars decreases in Home  these changes will be reflected in world relative demand and supply  changes world relative prices. it affects a country’s terms of trade. As a result. The tariff on food imports in Home will decrease the relative world price of food  increase the relative world price of cars. An import tariff of T% increases the domestic price: PD = PWorld (1 + T/100) An export subsidy of S% also increases the domestic price. it increases Home’s welfare and decreases Foreign’s welfare. Import-biased growth improves a country’s terms of trade and welfare. Therefore. A tariff on food imports in Home  PF/PC increases  relative demand for food will decrease  relative supply of food will increase.If export-biased abroad (= import-biased at home): it raises welfare at home. Import tariffs and export subsidies Both import tariffs and export subsidies make domestic prices differ from world prices. PD = Pworld (1+S/100). 2 Suppose. this will also change world relative supply and demand. because producers should be indifferent about selling at home or trading. Tariffs and subsidies do not only change terms of trade. A country also exports reduce the price of its exports and decrease its terms of trade + welfare. the Specific Factors. is based on the assumption that the world consists of two countries. not necessary to specify where these differences exactly come from. Export subsidies by foreign countries on goods that A country imports reduce the price of its imports and increase its terms of trade + welfare. they also distort domestic production and consumption incentives. A country also imports reduce the price of its imports and increase its terms of trade + welfare. The overall welfare effect of an import tariff or export subsidy is a combination of this direct effect and the terms of trade effect: An export subsidy unambiguously lowers domestic welfare! An import tariff raises domestic welfare if the terms of trade effect dominates the direct distortion effect. 5.When they open up to trade. The Standard Trade Model captures some essential ideas of the Ricardian.When countries do not trade these differences result in different relative goods prices. This typically lowers welfare. The terms of trade of a country refers to the price of goods the country exports relative to the price of goods it imports. If the country is really small. these differences in relative goods price mean that countries have an incentive to actually start trading. Import tariffs on a good decrease the relative world price of that good. This is not the case in reality! Export subsidies on a good decrease the relative world price of that good. An export subsidy by the domestic country reduces domestic welfare to the benefit of the foreign country. Summary 1. 2. and the Heckscher-Ohlin model. Caveats 1. 4. . Countries trade because of differences in production possibilities . Important effect of trade: it changes relative prices. 21 . The findings that a tariff/subsidy has a different effect for the country which imposes them and the other country. 2. Import tariffs by foreign countries on goods that A country exports reduce the price of its exports and decrease its terms of trade + welfare. these effects will also be really small. To analyze important issues in international economics. 3.- An import tariff by the domestic country can increase domestic welfare at the expense of the foreign country. its terms of trade increase and its welfare may increase. output increases by more than x%.Therefore. . When a country imposes an import tariff. When production is characterized by IRS. and knowledge spillovers).6. Economies of scale mean that either larger firms or larger industries are more efficient. increasing returns to scale provide an incentive for trade. easy access for suppliers. reducing its welfare and increasing the welfare of foreign countries. 6. Diminishing returns to scale or diminishing returns to one factor are different! Diminishing returns to one factor = when only that factor input is increased by x%. increasing returns to scale can explain these patterns: . labor pooling. External economies of scale: occurs when the cost per unit of output depends on the size of the industry (e. When a country imposes an export subsidy. Lecture 8 – External Economies of Scale (Ch. Internal economies of scale: occurs when the cost per unit of output depends on the size of the firm. 7. However. its terms of trade decrease and its welfare decreases. output rises by less than x%. they will import the goods they are not specialized in. 22 .g.7) Some trade patterns cannot be explained by differences in technologies or resources endowments. A larger scale is more efficient: the cost per unit of output falls as a firm or industry increases output. .It allows for specialization . there is no incentive to trade.They will export the goods they are specialized in. Trade can be mutually beneficent: . 8.In autarky it is not possible to exploit possible economies of scale. Therefore. If there are no differences in technologies or resource endowments and the production is characterized by constant returns to scale.IRS provide an incentive for countries to specialize in the production of certain products. but in which another country is not specialized. output rises by less than x%. Export-biased growth reduces a country’s terms of trade. Diminishing returns to scale = when all factors’ input is increased by x%. However. because using available resources in one or few sectors makes them more productive than using them in many sectors. Import-biased growth increases a country’s terms of trade. increasing its welfare and decreasing the welfare of foreign countries. the relative prices will be the same in both countries. IRS or economies of scale: when all inputs to an industry increase by x%. but in which another country is specialized. it pays to specialize. An industry with internal economies of scale usually consists of a few large firms and is characterized by monopoly or oligopoly. but because of history or chance. There is no guarantee that the “right” country will produce goods that are subject to external economies of scale. offering lower prices. it will reach a lower AC than a start-up in another country. some trade patterns are a result of differences in initial prices. Knowledge spillovers: workers from different firms can more easily share ideas that benefit each firm when a large and concentrated industry exists. External economies of scale provide an explanation for specialization patterns in various countries: Concentrating production of an industry in one or a few locations can reduce the industry’s costs. Since the average costs fall. since one country needs to supply for world demand. 3. world prices fall because of trade! However. It is more efficient to produce in the country with the lowest AC. 2. and will end up producing more than the other country. even if the individual firms in the industry remain small. The wrong location may end up producing it. but forward-falling. even though in the long run the AC of the other country will be lower. a country may have external economies of scale. Implications 1. easier to learn from nearby concentration of competitors. the other country has an advantage and will produce everything. 23 . 2. Labor pooling: Concentrating production of an industry in one or a few locations can reduce the industry’s costs. Also. With trade: The country that has the lowest average cost will end up producing everything. Specialized equipment or services (suppliers) may be only supplied by other firms if the industry is large and concentrated. If a country starts producing first.Chance. Without specifying the drivers of external economies of scale: The larger the industry.Historical events . Lock-in may prevent more efficient producers from emerging. Because there are always new firms willing to enter the market. .An industry with external economies of scale usually consists of many small firms and is characterized by perfect competition. the lower the average costs. because it has an advantage. the lower the prices. Without trade: Each country will produce they quantity it demands. even though this is not the most efficient choice. Because of this. Reasons why external economies of scale occur 1. The form of the supply curve changes! It is not upward-sloping. Since under perfect competition prices reflect production costs: The larger the industry. even if the individual firms in the industry remain small. Gains from trade in the presence of external economies of scale In general: The whole world gains from trade based on external economies of scale, because it allows countries to specialize, which makes production more efficient, therefore prices are lower. Welfare increases. However, some countries do not gain from trade. If a country is more efficient in the production of a certain good, but another country has external economies of scale due to history or chance, the price paid in the more efficient country with trade is higher than the price they would pay in autarky. This is an incentive to protect its own industry, until it is large enough to compete with the country that now produces the good. Rapid changes in the location of production are possible, if a country is able to reduce its production costs (technological innovation, better education population), it may result in rapidly attracting whole industries. External economies of scale speed up this process. Dynamic external increasing returns to scale (learning curve): if production costs fall with cumulative output over time. This can result in the same effects as static IRS: - Lock-in of initial advantage - Rapid changes in the location of production - Some countries worse off under trade than under autarky. Theoretically, it can be justified to protect your economy until it gained experience enough to compete with other countries (infant industry argument), or a large enough cluster is present, so it can compete on world markets. In practice: - Hard to identify which industries to protect, and which industries will never be able to compete. - Protection may reduce the incentive to innovate and produce efficiently. External economies of scale are also important for interregional trade. To what extent external economies of scale can explain differences in regional economies depends on whether good are tradable or not. Shares of employment in sectors with non-tradable goods are similar in different regions. However, this is not the case for tradable goods. Here lies a big role for economies of scale. Production of most tradable goods is to a great extent localized within a country. Determinants of regional specialization - Historical coincidence. - Geography Summary 1. Trade need not be the result of comparative advantage. Instead, it can result from increasing returns or economies of scale, that is, from a tendency of unit costs to be lower with larger output. 2. Economies of scale give countries an incentive to specialize and trade even in the absence of differences in resources or technology between countries. 24 3. Economies of scale can be internal (depending on the size of the firm) or external (depending on the size of the industry). 4. Economies of scale can lead to a breakdown of perfect competition, unless they take the form of external economies, which occur at the level of the industry instead of the firm. 5. External economies give an important role to history and accident in determining the pattern of international trade. - When external economies are important, a country starting with a large advantage may retain that advantage even if another country could potentially produce the same goods more cheaply. 6. When external economies are important: the free trade price can fall below the price before trade in both countries 7. When external economies are important, countries can conceivably lose from trade. 8. Within countries: economies of scale typically even more important to determine interregional pattern of trade and clustering of tradable goods production. Lecture 9 – The Instruments of Trade Policy (Ch.9) Total welfare effect of a certain trade policy = terms of trade effect + welfare effect of the policy distorting production and consumption choices + welfare effect of a change in government revenue. Partial equilibrium framework: We focus on the effects of different trade policies in a single industry without considering the full effect in the other sectors or countries. 1 Import tariffs 2 types of tariffs: Specific tariff: a fixed charge for each unit of imported goods. Ad valorem tariff: a fraction of the value of imported goods. Effective rate of protection: change in value (measured by goods prices) that firms in an industry add to the production process, due to a change in trade policy. Only if the firms makes and sells the good all by itself: effective rate of protection = tariff rate. (PT – P)/P = [(P(1+t) – P]/P = t This is almost never the case, because of the use of intermediate products: effective rate of protection DOES NOT EQUAL tariff rate. Value added by firm: P – Pintm After tariff: P(1+t) – Pintm Effective rate of protection: [(P(1+t) – Pintm) – (P – Pintm)] / (P – Pintm) = t [P/(P – Pintm)] > t An import tariff on the intermediate product will result in a negative effective rate of protection. Effective rate of protection = -t[Pintm/(P – Pintm)] < 0 Suppose, a tariff affects a single market, cars. In autarky: PC > P*C 25 - With trade: Foreign exports cars Home imports cars from Foreign. Import demand curve (for Home): at each given price: MD = D – S Export supply curve (for Foreign): at each given price: XS* = S* - D* In equilibrium: MD = XS D – S = S* - D* D + D* = S + S* World demand = world supply Home imposes an import tariff on Foreign’s cars: Small country (no effect on world relative supply, demand, and prices) P*C remains the same. P*C = PW Home: PT = PW + t As a result of the tariff, imports decline. Large country (does have an effect on world relative supply, demand, and prices) Home’s prices rise to PW + t. Lowers Home’s demand and increases Home’s supply. Since Home is large, this also affects world relative demand and supply. World relative demand decreases and world relative supply increases. This also changes Foreign’s price: Foreign’s price decreases. In the new equilibrium, it has to hold that: 1. Home consumers are indifferent between buying abroad or at home. 2. Foreign producers are indifferent between selling at home or abroad. PT = P*T + t PT > PW > P*T 26 but below price). A tariff raises the price in the importing country. but above price). (Area below demand curve. Consequences of a tariff: Consumer surplus decreases Producer surplus increases Government revenue increases by tQT Overall effect on welfare = ΔCS + ΔPS + Δ government revenue 27 . due to fallen prices. (Area above supply curve. due to increased prices. and therefore: Benefits producers (measured in Producer Surplus) Hurts consumers (measured in Consumer Surplus) Increasing government revenue. Foreign’s car exports fall. Consumer surplus measures the amount that consumers gain from purchases by computing the difference between the price actually paid and the maximum price they would be willing to pay for each unit consumed. Producer surplus measures the amount that producers gain from sales by computing the difference between the price received and the minimum price at which they would be willing to sell.- Home’s prices rise by less than the import tariff imposed. Home’s car imports fall. since there are no Terms of trade gains. Large country: Possible positive welfare effect if the Terms of Trade effect > efficiency loss. More focus on export Less domestic supply  Price increases CS decreases PS increases Government revenue decreases by sQS If a country is large enough: changes in domestic demand (decrease) and domestic supply (decrease) will also affect world markets. Overall effect on welfare = ΔCS + ΔPS + Δ government revenue = efficiency loss + Terms of trade loss (this is a welfare gain for Foreign). 2 Export subsidy Specific Ad valorem In equilibrium firm should be indifferent between exporting and supplying the domestic market: PS = P*S + s <=> PS .s = P*S An export subsidy raises the price of the good in the domestic market. 28 .Small country: Always a negative welfare effect. Relative price will go down: Terms of trade deteriorates. but only an efficiency loss. Quota license holders get revenue (quota rents) from selling imports at high prices. 29 . A binding import quota will increases prices of imports (quantity demanded exceeds quantity supplied at home and abroad). The profits or rents from this policy are earned by foreign producers. As a result of an import quota: Producers benefit Consumers lose Government revenue does not change. There is a welfare loss for the importing country. the quota rents increase government revenue. A voluntary export restraint (VER) is like an import quota.3 Import quota An import quota is a restriction on the quantity of goods that may be imported. often in return for relaxation of other trade policy. because there is not import tariff. except it is requested by importing country. If the government is a quota license holder. Government agencies are obligated to purchase from home suppliers.efficiency loss from consumption and production distortions . 5. the government of the importing country typically receives no revenue. With voluntary export restraints and import quotas. and local content requirements. voluntary export restraints. A LCR does not provide government revenue nor quota rents and it’s hard to enforce.S. Tariffs drive a wedge between foreign and domestic prices. It may be specified in value terms: a minimum share of the value added must represent value added in home.Domestic consumers lose .In the small country case. The costs and benefits of a tariff or other trade policy instruments can be looked at using the concepts of consumer and producer surplus.Safety.U. Or in physical units. it does not limit imports. even when they charge higher prices (or have inferior quality) compared to foreign suppliers = LCR only for government purchases Bureaucratic regulations . . a tariff is fully reflected in domestic prices. Export credit subsidies . 10. For domestic producers or intermediates. it protects them in the same way an import quota would. . 2. quota. but allows them to import more if they also produced more Home parts. Export-Import Bank subsidizes loans to U. exporters = same effect as export subsidy Government procurement .A subsidized loan to exporters . world price falls and domestic price rises by less than the tariff. foreigners typically gain by getting quota rents. quality. The overall welfare effect of a tariff.S.Domestic producers gain . With import quotas. For firms using intermediates. . However. or customs regulations can act as a form of protection and trade restriction.In the large country case. it does raise the price of intermediates. or export subsidy can be measured by . Lecture 10 – Trade policy in practice – (no) free trade? (Ch. 12) 30 .A local content requirement (LCR) is a regulation that requires a specified fraction of a final good to be produced domestically.The government collects tariff revenue (or not) 3. 11.terms of trade gain or loss (if country is large) 4. = same effect as import quota Summary 1. health. . subsidy. Trade restrictions may stay intact. So: no quota.Collective action Assumptions: 1. Parties live up to their promises. if consumers do not care too much about them. trade policy does not follow this principle. there is no collective action problem.Groups that lose from trade. 2. because his benefit is not large enough to compensate the cost of advocating free trade. these funds come from interest groups who do not have a collective action problem. Often.Labor standards 1 Political economy of trade policy In democratic societies: politicians have incentives to set policies that gains them the most votes. Collective action problem: . why do we observe active trade policies and protests against free trade? 1. Only one policy 3. 31 .If countries benefit from trade.Policies that impose large losses for society as a whole. Two competing politic parties 2. . . but do have special interest in a particular policy. But they also need money to campaign for votes. but each individual consumer has no incentive. Collective action models explain why the median voter theorem does not work for trade policy. Politics: . Other gains/disadvantages from trade not taken into account by models: . Objective is to get majority of votes 4.Consumers as a group have an incentive to advocate free trade. Models: Politicians care about maximizing their own political success.Countries retaliate against other countries’ trade policy. . actively lobby to protect their interests.Median voter theorem: Parties pick policies to court the “median voter” and attract the most votes. and the interest groups strongly advocate them. and no import tariffs! However. export subsidies. Choice of policy is determined by how many voters will be pleased. rather than national welfare. but small losses on each individual may therefore not face strong opposition. For these individuals. .Environment . politicians need money to campaign for them.Infant industry argument . each individual has a strong incentive to advocate the policy he desires: tariff. or quota. Trade policy in practice To advocate popular policies.For individuals with large individual losses. Other arguments: Domestic market failures .Losers can always be compensated.If there’s no free trade. but it also affects other countries. It is very doubtful that this works in practice.Excessive policy making (bananas. restrictions decrease welfare.) No trade! Theoretical argument: A country can gain from imposing import tariffs because of a positive terms of trade effect. Ricardian.Free trade expands consumption possibilities. instead of using them for productive purposes . Political arguments: . since countries as a whole gains from trade. 32 .Private firms can fully profit from technological benefits: lack of innovation. .Environmental cost for society because of production. Heckscher-Ohlin models: . Make trade. who can retaliate against the restrictions. international trade agreements are very important. To prevent trade wars.Reduce international competition . countries will choose protectionism. or not? Models say: trade makes a country as a whole better off. Increasing returns to scale: Restrictions: . In an extreme case: trade wars.Bilateral agreements . .All countries could enact trade restrictions. or on wages.Rent seeking: people spend time and other resources seeking quota rights and the profit that they will earn.World Trade Organization . countries need an agreement that prevents a trade war or eliminates the existing protection. . This explains why international negotiation are very important: . restrictions decrease welfare. Even if there is only a threat of restrictions being imposed: . cucumbers etc. but firms do not fully pay for it: too much pollution. even if it is in the interest of all countries to have free trade . Only if terms of trade effect dominates negative welfare effect and if other countries do not retaliate.Limit gains from external economies of scale . . .Trade policies do not only have domestic consequences. Without coordination. not war! Trading countries are less likely to go to war.Reduce learning (trade contains knowledge).Badly functioning capital markets: less firm investment and growth. Specific Factors. although the best for everyone is free trade.To avoid this. policies will be manipulated by political groups  welfare decreases.High underemployment: restrictions on labor mobility.Regional Trade Agreements Free trade. . marginal social benefit is not accurately calculated by the producer surplus. Anti-globalization “Low wages and poor working conditions in developing countries. Efficiency loss calculations are thus misleading. On the contrary. The infant industry argument was not valid in practice: . . workers in developing countries are better off.Extremely high tariffs (even prohibitively high) . not through trade restrictions.In principle. that did not adopt these policies. That is true. As a result. people advocate free trade. many developing countries started to liberalize trade. including firms that needed to buy imported inputs for their products.It promoted inefficiently small industries. Furthermore. Infant industry arguments Only by first protecting own industries. time-consuming regulations.Local content requirements. countries adopting import-substitution policies grew slower than countries that didn’t adopt these policies. With this market failure. Encourage domestic industries. that deteriorate the situation. But sometimes.New industries did not become competitive . . However. And anti-globalization movement is absent in developing countries. will they ever be able to compete on world-markets. Import-substitution policies were popular for developing countries in the 80s. by protecting them from competing imports .It involved complex. Situation is worse than in developed counties”. and because of the rapid growth of East-Asian countries.Import quotas . the benefit to domestic society can increase by increasing the positive sideeffects of domestic production (more knowledge spillovers)! This may work.Unclear when a market failure exists and its severity. It is difficult to say. but the evidence points out that increasing exports of developing countries led to growth. but typically: . . Suppose that externalities from production are not taken into account by private firms and investors. it’s hard to directly solve problems. 33 .Distortion of incentives to produce or consume may have unintended effects. When a tariff increases domestic production. it’s always the best option to tackle these failure directly.It set high tariff rates for consumers.Import-substitution industrialization involved costs and promoted wasteful use of resources: . but would the country benefit if there was no trade? On average.Addressing of market failures by government may be influenced by lobbyists. developing countries are against labor standards. but evidence much (much) more towards trade being a good thing Just two final thoughts: If trade is really that bad. Improving conditions in exporting sectors will have a small effect. To trade or not to trade? Overall. between New York and San Francisco. gains from trade depend on how you value all its pros and cons Difficult to put a number on this. they typically like them. also in developing countries. But the pollution haven effect is an issue. 1.when economic activity becomes concentrated in one region because of less strict regulations. Poor conditions are set by the countries itself. make their own choices. Environmental standards are often opposed to by developing countries. The solution is to promote sustainable development (this does not depend on trade). not by trade. They define their culture through the choices that they make. but it can set an example. and afraid for their own development. because they are afraid it will be used as a protectionism argument by rich countries. a change in working conditions is desirable. However. or between Peking and Shanghai? 34 . not through standards set by others. Culture arguments “Trade westernizes other cultures” This argument forgets that: People. Pollution haven . Why do we see it happening everywhere? 2. People do not have to consume foreign products. afraid of standards being used as a protectionism measurement. Why don’t we restrict trade between Rotterdam and Groningen. if they do. since most people don’t work in exporting sectors. relative factor endowments) exchange different varieties of the same goods. such that P > MC. Prices are set such that profit is maximized (monopolist or oligopolists). Mi: value of imports by industry i. If GLi = 0 Xi > 0 and Mi = 0. Especially relevant when a firm differentiates its good from rivals’ varieties of the good. only inter-industry trade. Only “North-South” trade can be explained by Ricardian or Heckscher-Ohlin model. 35 . Intra-industry trade Grubel-Lloyd index: GLi = 1 . In sectors with IRS (manufacturing) goods are differentiated: firms can set prices.PART 2 – INTERNATIONAL FINANCE Lecture 11 – Firms in the Global Economy (1) (Ch. Theory of imperfect competition Firms can influence the price of their product. This is similar with “NorthNorth” and “South-South” trade. GLi = 1  |Xi – Mi| = 0: large degree of intra-industry trade. Summary of stylized facts Trade in identical goods is important Trade between identical/similar countries is important New trade model needed Notice: Ricardo or Heckscher–Ohlin trade empirically not “dead”. New trade model Monopolistic competition. Large firms are more efficient than small ones.Mi| / (Xi + Mi) i: industry Xi: value of exports by industry i.8) The focus will be on firms that do not behave perfectly competitive. Imperfect competitive market structure: excess profits for large firms.|Xi . the firms that can affect prices. High GL-index: mostly intra-industry trade. Internal economies of scale: Average costs decrease as output increases. but can explain only trade of different goods between different countries. P = MC not possible with IRS: First units of output are sold at P < MC  loss at P = MC. Low GL-index: mostly inter-industry trade. Trade between identical countries Largest share of Western European trade is within Western Europe. or Xi = 0 and Mi > 0: only in Ricardian or Heckscher-Ohlin trade. Industries consist of monopoly/few large firms. Trade between similar countries (technologies. AC = nF/S + c). entry occurs until it’s not profitable anymore. Trade liberalization (integrating markets) has the same impact on P and n as economic growth in a closed economy. Monopolist realizes higher profits (incentive to export). 2. Equilibrium: p = AC P = c + 1/bn = nF/s + c = AC n* = sqrt(S/bF) Trade increases size  AC decreases (market size increases  S increases. Single firm sells less if number of competitors increases and if own price increases. Undetermined: share of firms in Home and share of firms in Foreign. Additionally: 1. they have the same price. each firm takes prices of competitors as given. Therefore. Assumptions: 1. If AC decreases: P decreases. Consumers gain since P decreases and n increases (lower prices.Monopolist: MR = MC Profits: (P – AC) x Q Trade liberalization = increase in market size. 2. Single firm sells more if aggregate demand for class of product increases and if price of rivals increases. 36 . same cost structure. more varieties – increases utility). Demand curve and MR-curve shift outwards. Monopolistic competition: more common than pure monopoly. Single firms differentiate their varieties from their competitors. _ Demand function: q = S [1/n – b(P – P)] q: a single firm’s sales S: total sales of industry n: number of firms in industry b: parameter that indicates price sensitivity of sales P: price charged by firm itself Pbar: average price in industry Additional assumption: All firms are symmetric: they have the same demand function. Assumption: no foreign monopolist exists and trade is costless. P = Pbar q = S/n Single firm: AC = F/q + c = n x F/S + c If n increases: AC increases If S increases: AC decreases Autarky equilibrium: MR = MC  P = c + 1/bn Assumption: Entry is free. n increases. When setting price. produced by the same industry Two new channels for gains from trade: Availability of new varieties Firms exploit economies of scale (lower average costs. lower price) Typically: smaller country gains more from liberalization to (intra–industry) trade. Lecture 12 – Firms in the Global Economy (2) (Ch. as compared to a larger country. Due to trade liberalization: Increased competition “Bad” firms are pushed out of the market “Good” firms expand. Net effect of firm selection: intra-industry wide average production increases  additional source for gains of trade. Typically: trade of manufactured goods among developed countries (=majority of world trade). inefficient firms lose.8) _ _ After trade liberalization. 37 . and the most efficient firms gain from trade liberalization. _ Firms with marginal costs larger than the intercept (P = 1/bn + P) cannot serve the market profitably.Reasons for trade in this setting: Product differentiation Internal economies of scale Significance of intra-trade industry Intra–industry trade: countries exchange different varieties. the intercept decreases (P = 1/bnautarky + P  = 1/bntrade + P) The least efficient firms exit the market. More generally: lower marginal costs lead to higher profits. Roughly 25–50% of world trade is intra–industry. dumping is considered to be unfair. However. Generally. the exporting firms are usually huge. 38 . Markets are segmented. If MRH = MC and MRF > MRH. Importance of trade costs They explain why only a subset of firms export. - If MC + t > intercept in foreign markets.However. Dumping can be a profit-maximizing strategy (jointly maximizing profits over two markets). Because of (fixed) export costs (administrative costs. Dumping Charging a lower price for exported goods than for goods sold domestically. They explain why exporters are larger and more efficient than non-exporters. It is also an example of price discrimination. Fixed export costs Difficult to estimate. costs of setting up a production plant abroad). It may only occur if: Imperfect competition exists: firms can set prices. a firm cannot export profitably. a firm profits from selling abroad. also costly: time needed to export. only a small share of firms is active on foreign markets. (Only if +10% of voting shares). However. This is driven by production cost differences between countries (Heckscher-Ohlin argument). Claim: anti-dumping tariff is only used as protection of domestic market. at the point where the domestic MR-curve equals the foreign price. typically: foreign affiliate produces intermediate goods for parent company. Foreign Direct Investment (FDI): Investment in which a domestic firm controls or owns a subsidiary abroad. a recent 39 . From an economic point of view dumping may be good for domestic consumers. Multinational: firm with a FDI. Greenfield FDI: Company builds a foreign production plant from scratch. Main reason: locate production close to large markets to avoid transport costs or tariffs (“tariff-jumping FDI”). Horizontal FDI: Foreign affiliate replicates production processes of parent company. mergers and acquisitions occur in surges. domestic company buys at least 10% of voting shares of foreign company. dumping”. Vertical FDI dominates FDI-flows between developed and developing countries. since they now face a lower price.With price dumping: there is a kink in the MR-curve. Vertical FDI: Buyer-seller relationship between foreign affiliate and parent company. where it turns in to a horizontal line. Brownfield FDI: (Mergers & Acquisitions). Horizontal FDI dominates FDI-flows between developed countries. Greenfield FDI is more stable. A firm can only attain this kinked MR-curve if it limits domestic sales to the amount “domestic sales. Multinationals are usually larger and more efficient than other firms in the industry (including other exporters). Additional trade-off: Horizontal FDI: trade-off between per unit export cost t and fixed cost F for setting up a production plant abroad. high transport costs or tariffs. Vertical FDI Trade-off between cost savings due to lower factor prices abroad and fixed cost of setting up a production plant abroad. the firm has an incentive to engage in horizontal FDI (likely when foreign sales are large). there appears to be no theoretical explanation of this law. Vertical FDI instead of outsourcing: 1. IF t(Q) > F. IRS in production  incentive to locate production in fewer locations. Why not outsourcing or offshoring? Internalization decision: whether to keep production in-house (vertical FDI) or to outsource it. 2. 40 . Internalization advantages: cost-saving to undertake foreign production within the firm. possible economies of scale when outsourcing).trend is reshoring foreign production back to the home country (because of poor institutional environment). Technology transfer: transfer of knowledge is easier within a company than through market transactions with separate firms. However. Zipf’s Law: There is a statistical relationship between the size of a city and the geographical concentration of economic activity. Avoiding hold-up. However. Closed economy: expenditures by buyers = income for sellers = value of production Gross National Product: value of all final goods and services produced by a country’s factors of production in a given time period. When do multinationals arise? (OLI) Ownership advantages: beneficial for domestic firms to own foreign plant – due to patents or trademarks. knowledge is not easily transferable. Horizontal FDI and proximity-concentration trade-off: (leads to producing good in multiple facilities) High export costs  incentive to locate production near customers. FDI activity is concentrated in sectors with high trade costs. Patents or property rights may be weak. Location advantages: low input prices.13) National income = income earned by a country’s factors of production. Vertical FDI: different stages of production processes in-house. Lecture 13 – National income accounting and Balance of Payments (Ch. consumption. Investment 3.investment Y = C + I + G + CA CA = EX – IM = Y – (C + I + G) CA > 0: net foreign wealth increases (production > domestic expenditures) CA < 0: net foreign wealth decreases. Gross Domestic Product: value of all final goods and services produced within a country in a given time period. Y . Current account + Financial account + Capital account = 0 41 . pension payments to expatriate retirees. I . copyrights and trademarks.national income. Capital account: flows of special categories of assets: typically non–market. Financial account: accounts for flows of financial assets (financial capital). National saving S=Y–C–G S = (Y – C – T) + (T – G) = S private + S government S = Sp + Sg CA = Y – (C + I + G) ---> = Sp+Sg-T CA = (Y – C – G) – I CA = S – I CA = net foreign investment CA = Sp + Sg – I CA = Sp – government deficit – I (or plus if proficit) Sg = T – G Balance of payments Balance of payments records all transactions between domestic and foreign country. C .government purchases. Current account balance: exports – imports GNP – depreciation + unilateral transfers = national income Unilateral transfers: payments of expatriate workers to home country. G . Private consumption (typically dominates) 2. Government consumption 4. Depreciation and unilateral transfers are mainly exogenous to government policy: GNP and national income are therefore used interchangeably.GNP consists of: 1. Accounts Current account: accounts for flows of goods and services (imports and exports). or intangible assets like debt forgiveness. foreign aid. EX: expenditures on domestic production. GDP = GNP – payments from foreign countries for domestic factors of production + payments to foreign for foreign factors of production. non– produced. Open economy Y = Cd + Id + Gd + EX. Liquidity: need for liquidity increases with price of transactions and with the quantity of transactions increases. Prices: the higher the price of goods and services. Capital account: records special transfers of assets. However. Interest rate on non-monetary assets. Financial account: difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens. deposits of currencies.Current account 1.15) Money: Medium of exchange Unit of account Store of value Liquid asset Bears little or no interest Liquid assets: currency in circulation. 2. Lecture 14 – Money. and Exchange rates (1) (Ch. Financial outflow: domestic citizens loan to foreigners by buying foreign assets. time deposits. works of art. and GNP because they are a way to rank countries. 3. the higher the money demand. 2. Merchandise 2. more impact on money demand. 42 . 1/3 literacy rate. We care about national income. Income receipts The world as a whole always has a current account surplus or deficit. debit card accounts.e. usually of minor importance. Interest rate on non-monetary assets. even though in theory it should be equal to zero. purchase of these assets is a debit (-): domestic economy gives up money. stocks. and 1/3 GDP per capita. a better measurement is the Human Development Index: 1/3 life expectancy. Income: higher income implies more demand for goods and services: i. Interest rates. Risk of unexpected inflation – reduces purchasing power of money. checking deposits. sale of these assets is a credit (+): domestic economy acquires money. Illiquid assets: bonds (can be traded). Determinants of aggregate demand: 1. Services 3. 3. Financial inflow: foreigners loan to domestic citizens by buying domestic assets. savings deposits. GDP. etc. loans. Determinants of individual money demand: 1. real estate. Change in domestic money supply 1. E$/€ increases: depreciation of the dollar. demand for assets ($) decreases. Ms = Md Ms/P = L(R. US investors supply $ and demand €. Md = P x L(R. return on deposits (€) decrease when E$/€ increases. lenders lose – overall no impact on money demand. Demand for assets (€) increase (higher interest rate). Y) Money supply and the exchange rate in the short run US: Home country. Since changes in future E$/€ are not related to changes in current E$/€. 43 . However. EU: foreign country E$/€ depends on the return on dollar deposits and the expected return on euro deposits.No risk of unexpected inflation: borrowers gain from unexpected inflation. Y): aggregate real money demand . MsEU increases  R€ decreases. (you need more dollars to get euros) Return on deposits ($) are not influenced by E$/€. 3. since the investor has to pay more now. Note: value of other currency doesn’t change! Change in foreign money supply 1. a current depreciation of the dollar decreases the return on assets (€). Y) Interest rates adjust so that money demand equals money supply. E$/€ increases: depreciation of the dollar.+ Md/P = L(R. 4. 2. Y) P: price level Y: real income R: interest rate on non-monetary assets L(R. MsUS increases  R$ decreases. Interest rate is independent of money supply. (Though price is increased) Long-run relationship between money supply and price level ΔP/P = ΔMs/Ms – ΔL(R. not interest rates. Demand for assets (€) decrease (lower return). Real output and income level are independent of money supply. 1. 4. Y and Ms/P are unchanged  long-run equilibrium. Since increase in money supply is permanent  firms adjust their prices  price level increases. Long run: Final goods prices and factors prices are flexible. An increase in money supply shifts LM-curve to the right  interest rate decreases to reestablish equilibrium on money market  domestic demand for investment goods increases  aggregate demand AD increases for a given price level  short-run equilibrium. Factor prices adjust to clear factor markets. EU investors supply $ and demand €. Price level adjusts so that real money supply stays constant. LM-curve: all combinations of R and Y.Y)/L(R. R.2. Short run: Final goods prices and factor prices are fixed due to ‘menu costs’. 2. E$/€ decreases: appreciation of the dollar. 3. This shifts back the LM-curve to its initial position. Only instrument of central bank is money supply.Y) 44 . Real output and income level only depends on a country’s factor endowments and technologies. demand for assets ($) increases. Aggregate demand increases. later a slight appreciation of the currency. and goods and money markets are in equilibrium. Demand for assets ($) decreases. 2. US price level increases in the long run. returns on assets ($) increase. changing prices influence interest rate and exchange rate in the long-run. Expected euro return-curve shifts right. Supply of € and demand for $ increases. Demand for assets ($) increases. Investors expect inflation for the future. 5. Notice: new exchange rate is still above initial exchange rate. An increase in the price level exactly compensates the increase in money supply! Open economy 1. because the expected euro returncurve shifted to the right. Exchange rate overshooting (Dornbusch) Initially a large devaluation/depreciation of the currency. expectations are also important. Since we now consider the long run. 4. Crucial for exchange rate overshooting: sticky prices. Increase in US money supply decreases R$. 3. However.16) Long-run approach: prices are completely flexible. E$/€ increases: depreciation of the dollar. Uncertainty of firms: increase in MS temporary or permanent? Firms keep prices fixed (menu costs) and just increase production (workers work harder and longer). real money supply in the US decrease. i.Positive (long–run) relationship between money supply and price level especially important for countries with no simultaneous changes in L! Economic mechanisms If Ms increases: Interest rate R decreases Lower interest rates imply higher demand for investment goods.e. E$/€ decreases: appreciation of the dollar. demand for assets (€) decreases. 45 . if workers demand wage compensation: Wages increase Production costs increase Prices increase Real money supply Ms/P decreases Interest rate R increases Smaller domestic demand for investment goods. demand for assets (€) increases. change in nominal money supply has a short–term effect on real money supply! Lecture 15 – Price levels and the exchange rate in the long run (1) (Ch. Supply of $ and demand for € increases. Transportation costs and different production costs under multinational activity. 46 . If absolute PPP holds. YEU) PUS = MsUS / L(RUS. Hardly holds in reality. t-1 with πt = inflation rate from t-1 to t. PPP implies that households have the same purchasing power in all countries. relative PPP holds as well. NOT vice versa! implies Absolute LOP for individual goods → absolute PPP ↓ implies implies ↓ Relative LOP for individual goods → relative PPP Monetary approach to exchange rates Long run: prices are flexible  prices always adjust so that absolute PPP holds.Law of One Price (LOP): If free trade is costless and if competition is perfect. Transportation costs and different forms of competition. YEU) decreases PEU increase to maintain equilibrium on European money market. t – πCH. the equilibrium exchange rate is determined by Ms. PEU = MsEU / L(REU. PEU / PUS = E€/S Ms increases: Proportional increase in PEU. Proportional depreciation of € relative to $. t-1) / E€/CHF. ΔPNL/P – ΔPCH/PCH = ΔE€/CHF / E€/CHF πNL. t = (E€/CHF. the same good is sold at the same price in all trading countries. since PPP holds. Reasons for violation of LOP: Different taxes across countries. YUS) If absolute PPP holds. t . R. Comparable prediction as previous long-run model without PPP.E€/CHF. REU increases: L(REU. and Y of both countries. Absolute PPP: Holds if exchange rates equal level of average prices across countries: E€/CHF = PNL/PCH Relative PPP: Holds if the change in exchange rates equals the change in relative prices. Purchasing Power Parity (PPP): Application of LOP for all goods and services (or a representative basket of goods and services) across countries. PNL = PCH x E€/CHF (how many e it costs to get 1 frank) PNL = Aggregate/average price level in the Netherlands PCH = Aggregate/average price level in Switzerland - Ratio of average prices determines exchange rates. Fisher equation When the equation holds. there is no incentive for investors to relocate their investments.- Proportional depreciation of € relative to $. Proportional appreciation of € relative to $. due to transportation costs: prices differ between countries.16) Real exchange rate approach: Composition of basket of goods is allowed to differ between countries. Due to PPP. since PPP holds. changes in relative aggregate prices equal relative change in exchange rates. Lecture 16 – Price levels and exchange rates in the long run (2) (Ch. Services are often non-tradable. If relative PPP holds. Interest parity condition: REU – RUS = (Ee€/$ . YEU) increases PEU decreases to maintain equilibrium on money market. t Fisher effect: An increase in the expected domestic inflation rate ceteris paribus leads to an equal increase in the interest rate on domestic assets. Real exchange rate: Rate of exchange for goods and services across countries. goods which are uniquely supplied to one country. Fisher effect Relationship between nominal interest rates and inflation. This leads to an adjustment of the exchange rate. depending on market structure. Reasons for failure of PPP Trade barriers and non-traded goods: Transportation costs and trade restrictions imply that some goods are not traded. Y): Prices adjust to maintain equilibrium on money market. Causal relationships: Exogenous change (Ms.E€/$) / E€/$ <. 47 . if they expect the higher interested to be outweighed by a depreciation of the currency. Imperfect competition: “Pricing to market”: same good is sold at different prices in different markets. R. since PPP holds. Relative price of goods and services across countries. households also demand non-tradable goods. the increase in the PUS leads to a depreciation of $. Even if good is traded. REU – RUS =πeEU. t – πeUS. since PPP holds. An increase in RUS decreases real money demand: PUS has to increase for an equilibrium on the US money market. Different outcome than previous model! YEU increases: L(REU. Nominal exchange rate changes proportionally  no change of the real exchange rate. total productivity only depends on factor endowments and technologies. q = 1 Determinants of the real exchange rate 1. Real exchange rate decreases. Technological progress in Europe 1. Price of US goods relative to the price of EU goods increases 4.q$/€ = E$//€ x PEU / PUS Real depreciation of the dollar: US basket of goods becomes less valuable relative to EU basket. Increase in US money supply 1. However. Vertical RS-curve: In the long run. No change of the real exchange rate. RD for US goods increases 2. Nominal exchange rate 2. World relative demand for US goods: increase in relative demand for US goods increases relative price of US goods. 2. real appreciation of the dollar. Real exchange rate decreases. Relative supply of US goods: Increase in relative supply of US goods decreases relative price of US goods: PUS / (PEU x E$/€) decreases  decrease of the value of US goods relative to EU goods. 3. RD-curve shifts to the right 3. Increase of money supply changes price levels. real depreciation of the dollar. Upward-sloping RD-curve: increase in q$/€ = E$//€ x PEU / PUS implies that US goods become cheaper relative to EU goods  demand for US goods increases relative to demand for EU goods. Price of EU goods relative to the price of US goods decreases 4. Increase in US inflation: increase in US nominal interest rate. an increase in US prices. Proportional increase of the price of US goods in the long run 2. foreign exchange market is 48 . RS of EU goods increases 2. Nominal exchange rate: E$/€ = q$/€ x PUS / PEU 1. RS-curve shifts to the left 3. Increase in relative demand for domestic (US) goods (tradable and non-tradable). PUS / (PEU x E$/€) increases  increase of the value of US goods relative to EU goods. More of the US basket of goods has to be spent to obtain one EU basket of goods. When absolute PPP holds. Increase in relative demand for US goods does not necessarily imply a proportional decrease in relative demand for EU goods  PUS increases. No real consequences 3. Nominal exchange rate changes proportionally  no change of the real exchange rate. Preferences for US goods increase 1. 3. a decrease in US real money demand. also the real exchange rate. Still.(πeUS – πeEU) Expected change in real exchange rate = expected change in nominal exchange rate + expected inflation.1 = r For derivation: see slides. 4. (1) Has a negative effect on the nominal exchange rate. Changes in relative demand/supply for/of domestic goods: Changes of the real exchange rate Increase in RD for domestic goods decrease real exchange rate.only partially influenced by changes in relative demand. since EU demand for tradable US goods increases. Combining with interest parity condition (RUS – REU = (Ee$/€ . Real exchange rate increases – a real depreciation of the dollar. Differences in real interest rates re ≈ R – πe r: real interest rate R: nominal interest rate πe: expected inflation rate Correct expression: (1+R) / (1+π) = 1+r  (1+R) / (1+π) . (1) Price level in US decreases and (2) income in US increases. real exchange rate decreases. q$/€ = E$/€ x PEU / PUS (qe$/€ . Summary Determinants of nominal exchange rate: Changes in monetary factors: no changes of real exchange rate.E$/€) / E$/€ . only the nominal exchange rate.E$/€) / E$/€ RUS – REU = (qe$/€ .q$/€) / q$/€ + (πeUS – πeEU) Nominal interest rate differences = real depreciation of domestic currency + expected inflation rate differences between countries. nominal exchange rate changes as well. Interest rate differences Fisher effect is too simplistic. Real factors change the real value of goods. Crucial for real exchange rate approach: Real changes (demand/output) do not translate 1:1 into foreign exchange market since part of the goods is non-traded. Increase in relative supply of domestic (US) products. since the price level in US relative to the price level in EU increases. Increase in RS of domestic goods: ambiguous effect on nominal exchange rate.q$/€) / q$/€ = (Ee$/€ . The effect of an increase in relative demand for domestic goods has an ambiguous effect on the nominal exchange rate. US goods become relatively cheaper. since relative PPP does not hold. (2) Has a positive or negative effect on the nominal exchange rate. since US demand for tradable EU goods increases  PEU increases. Monetary factors do not change the real value of goods. 49 . + + + + D D Y = Y (q. Increase in ‘home bias’: AD increases for a given exchange rate  DD-curve shifts right. Value of imports in terms of domestic currency increases. no adjustment of prices due to short-run analysis. Assumption: Volume effect dominates value effect: increase in real exchange rate overall decreases value of imports. The slope of the AD-curve is smaller than 1.When R and π are ‘small’. (Y-T). makes domestic goods cheaper relative to foreign goods. Decrease in T: AD increases for a given exchange rate  DD-curve shifts right. since there are savings. Increase in I: AD increases for a given exchange rate  DD-curve shifts right. Aggregate output Y will increase as well.q$/€) / q$/€ + (πeUS – πeEU) Leads to: reUS . expressions are similar. Approximation reUS – reEU = (RUS – πeUS) – (REU – πeEU) Combining with: RUS – REU = (qe$/€ . An increase in the nominal exchange rate. Increase in G: AD increases for a given exchange rate  DD-curve shifts right. (Y-T). G) Aggregate demand = Aggregate output: D = Y There is always an adjustment of production. Assumption: investments are partially financed by credits  DD-curve shifts right. + + + + S D D Short run: prices are fixed: Y = Y = Y (q. ceteris paribus.reEU = (qe$/€ . Volume of imports decreases 3.17) Determinants of aggregate demand Cp Ip G CA Real exchange rate q Increase in real exchange rates increases price of foreign goods relative to price of domestic goods: 1. AD increases with nominal exchange rate. I. The relationship between exchange rate and AD is illustrated by a move along the DD-curve. 50 . Increase of preferences for today: consumption increases and savings/investments decline. I. Volume of exports increases 2.q$/€) / q$/€ Lecture 17 – Exchange rates and open economy macroeconomics (Ch. G) An increase in net income (Y-T) has a positive effect on YD because of the assumption of home bias: positive effect on an increase in (Y-T) dominates the negative effect of imports. Decrease of P relative to P*: AD increases for a given exchange rate  DD-curve shifts right. Demand for foreign currency increases 3. Decrease in preference for liquidity 1. Depreciation of domestic currency (E increases) 3. Depreciation of domestic currency (E increases) 4. interest parity condition must hold: RUS – REU = (Ee$/€ . Real money demand decreases 2. Increase in Ee 1. Interest rate R increases 3. R decreases 2. Appreciation of domestic currency (E decreases) 4. Depreciation of domestic currency (E increases) 4. Y)) 51 .E$/€) / E$/€ Money market equilibrium: M/P = L(R. Investors expect domestic currency to depreciate in the future 2. Nominal exchange rate E decreases (interest parity condition). Negative relationship between Y and E in order to keep domestic money market and foreign exchange market in equilibrium. AA-curve shifts upwards. Equilibrium values for nominal exchange rate and aggregate supply imply: Equilibrium on goods market (YS = YD) Equilibrium on money market (M/P = L(R. AA-curve shifts downwards. R increases for equilibrium on money market 3. AA-curve: all combinations of output and nominal exchange rate. Depreciation of domestic currency (E increases) 4. Real money demand increases (MD-curve shifts downwards) 2. R decreases 3. Y) Short-run equilibrium on money market Increase in real income Y 1. Demand for foreign deposits increases 3. AA-curve shifts upwards. Increase in money supply 1.Due to international capital mobility. AA-curve shifts upwards. AA-curve shifts upwards. Real money supply decreases 2. Increase in R* 1. Increase in price level 1. Demand for foreign assets increases 2. but there is still excess demand for domestic goods. Temporary increase in money supply Money market: decrease in R Foreign exchange market: decrease in R decreases demand for domestic deposits and domestic currency. MoFleFi: Monetary policy with Flexible exchange rates works Fine (fiscal policy doesn’t). Above AA-curve: either (1) nominal exchange rate too high for equilibrium on foreign exchange market. Temporary changes in monetary and fiscal policy Crucial: policy measures are temporary and do not influence expectations about the future.Simultaneous equilibrium on goods market and money market (DD-curve and AA-curve combined) Above DD-curve: excess demand since nominal exchange rate is ‘too high’. Adjustment of nominal exchange rate: equilibrium on foreign exchange market and money market. 52 .  Move on DD-curve to the right/upwards (No shift of DD-curve since positive relationship between E and Y is already represented by the positive slope of the DD-curve). R increases for equilibrium on the money market. Fiscal policy: Government changes government expenditures and taxes. demand for domestic goods and production increase. or (2) Y too high for equilibrium on money market.  DD-curve shifts to the right Money market: real money demand increases due to increase in Y. Monetary policy: Central bank changes money supply.  AA-curve shifts upwards Goods market: increases in E makes domestic goods relatively cheaper. Increase in government expenditures Goods market: demand and production of domestic goods increases. The domestic currency depreciates: E increases for given Y. Appreciation of domestic currency and increase in output: demand for domestic goods decreases and supply of domestic goods increases until equilibrium is realized. Increase in money supply: Domestic interest rate increases  domestic currency depreciates (E increases) 3. Policies to maintain full employment Assumption: There is initially no involuntary unemployment and output is at its ‘natural level’. 1. Increase in domestic money demand increases domestic interest rate  increase in demand for domestic deposits and currency  domestic currency appreciates (E decreases)  AA-curve shifts downwards. There may be unemployment. Exogenous shock: temporary shift of world preferences against domestic goods. 3. Increase in government spending: DD-curve shifts to the right  Y increases  R increases  E decreases 53 . Potential stabilization policies: 2. Increase in government spending: leads to initial equilibrium Exogenous shock: Increase in money demand (preference for liquidity increases) 1. Increase in money supply: domestic currency depreciates and income Y increases. A decrease in taxes T. Potential stabilization policies: 2. but that is completely voluntary.Foreign exchange market: The increase in nominal interest rate R increases demand for domestic deposits and currency  domestic currency appreciates (E decreases).  Move on the AA-curve to the right/downwards (No shift on AA-curve since negative relationship between E and Y is already represented by the negative slope of the AA-curve). which increases consumption. Decrease in demand for domestic goods  DD-curve shifts to the left. has the same qualitative effect. Permanent increase in money supply 1. Governmental interventions lead to ‘rent-seeking’ behavior (spending wealth on political lobbying to increase one's share of existing wealth without creating wealth).Problems with stabilization policies 1. quantitatively different results: 1. People now expect future depreciation of domestic currency 2. However. 54 . Permanent changes in monetary and fiscal policy Crucial: policy measures are permanent and influence expectations about the future exchange rates.  Larger decrease in demand for domestic deposits  Larger decrease in demand for domestic currency  Larger depreciation of domestic currency (larger increase in E): self-fulfilling prophecy. Long-run adjustment to permanent increase in money supply Permanent overtime: wages increase Demand increases permanently and production costs increase permanently. Further depreciation of domestic currency (E increases even more) AA-curve shifts further upwards because of expected further depreciation (expected further increase in E). Demand for domestic goods decreases at given exchange rate: DD-curve shifts to the left. Depreciation of the domestic currency (E increases) Qualitatively the same results. 4. Inflationary bias. firms increase their prices. Demand for domestic deposits and thus for domestic currency decreases further 3. Households reacts to policy measures: High employment is ensured  unions demand higher wages  firms increases prices  workers demand further wage increase  firms increase prices again. Increase in prices  real money supply decreases  real interest rate increases for equilibrium on money market  demand for domestic deposits and currency increases  appreciation of domestic currency (E decreases)  AA-curve shifts downwards. Demand for domestic deposits and domestic currency decreases 3. R decreases 2. 2. Anti-cyclical policy may become a pro-cyclical policy. Interpreting data by policy makers: which policy measures are necessary in order to reach full employment again? 3. Implementation lag: Time difference between decision to implement and actual implementation. Increase in public demand decreases private demand for domestic goods! Current account A large current account deficit is not desirable. All combination of nominal exchange rate E and income Y which lead to the desired level of the current account: + CA (E x P*/P. nominal changes do not affect real output). since future generation has to save more.In the long run. AA-curve shifts downwards). The slope of the XX-curve is flatter than the slope of the DD-curve. Net effect on Y: No changes. move on AA-curve) and expected further appreciation of domestic currency (Ee decreases. since output is only determined by factor endowments and technology. since increase in G is permanent. 55 . output returns to its initial level (only determined by factor endowments and technology. Permanent increase in G (or permanent decrease in T)  Increase in public demand  Y increases Money market: Real money demand increases  interest rate increases  appreciation of domestic currency (E decreases. The positive and negative effect on Y compensate each other. Y – T) = X Positive effect of E x P*/P: higher foreign price leads to more foreign demand for domestic goods: more exports  CA increases Negative effect of Y – T: More demand  more imports  CA decreases XX-curve: All combinations of E and Y that lead to the desired level of the current account. 18) Types of exchange rate regimes Fixed exchange rate (to ‘peg’ exchange rate): Central bank determines exchange rate. The adjustment path has a shape that somewhat looks like a J. the volume effect starts to dominate the value effect. domestic government bonds. The value effect dominates. Increase in G (decrease in T) 1. 56 . J-curve In the short run. An increase or decrease in the liabilities of the central bank often leads simultaneously to an increase or decrease of amount of foreign currencies supplied to the foreign exchange markets. gold. a depreciation of the domestic currency leaves import and export volumes constant. Liabilities: Deposits of private banks. Central bank intervention and money supply Balance sheet Foreign assets Deposits held by private banks Domestic assets Currency in circulation Assets: Foreign government bonds. the central bank can intervene if the exchange rate leaves the “band”. Managed floating exchange rate: Exchange rate is in principal determined by supply and demand. Any central bank purchase of assets automatically results in an increase in the domestic money supply. in the long run.Increase in money supply 1. AA-curve shifts upwards 2. foreign exchange reserves. etc. Fixing exchange rates Central bank: selling foreign currency and buying domestic currency  appreciation of domestic currency relative to foreign currency. DD-curve shifts to the right 2. Lecture 18 – Fixed exchange rates and foreign exchange intervention (Ch. New temporary equilibrium (AA and DD) above XX-curve: positive effect on the current account. loans to domestic bonds. domestic currency in circulation. New temporary equilibrium (AA and DD) below XX-curve: negative effect on the current account. when it exceeds the lower or upper bound. However. imports gradually decrease and exports gradually increase. while any central bank sale of assets automatically results the domestic money supply to decline. Flexible exchange rate: Only supply and demand determine the exchange rate. However. 3. Demand for domestic (foreign) currency increases (decreases). Domestic currency appreciates (E decreases). Decrease of supply of domestic currency and increase of supply of foreign currency 57 . change the exchange rate. The central bank has to compensate increase in domestic money supply by decreasing domestic money supply. Changes in supply of domestic currency. ceteris paribus. if the central bank increases domestic money supply after an increase in Y. goods prices are fixed: instrument of monetary policy is quasi non-existent under fixed exchange rates. Y) Increase in Y 1. With central bank intervention: Central bank buys domestic currency in exchange for foreign currency: 1. AA–curve shifts upwards. Decreases value of domestic currency relative to value of foreign currency Without intervention of the central bank: Depreciation of domestic currency. Increase of supply of domestic currency and decrease of supply of foreign currency on the foreign exchange market: 2. domestic interest rate remains constant and E remains constant. Monetary policy with fixed exchange rates In the short run. R increases for equilibrium on money market 2.Foreign exchange markets in equilibrium when R – R* = (Ee – E) / E Fixed exchange rate: Ee = E  (Ee – E) / E = 0  equilibrium when R = R* Equilibrium on money market: M/P = L(R. Alternative 1 Shortcut: concentration only on the foreign exchange market: 1. However. Decrease in R decreases demand for domestic deposits and for domestic currency. AA–curve shifts downwards.2. 2. production of domestic goods increases as well  DD-curve shifts to the right. the long-run level of output is only determined by a country’s factor endowments and technologies  DD-curve shifts back to its initial position. Without intervention of the central bank: Depreciation of domestic currency. Goods prices increase. when prices increase and output decreases: Real money supply decreases and real money demand decreases. Appreciation of domestic currency. FiFiFi: Fiscal policy with Fixed exchange rates works Fine (monetary policy doesn’t).. AA–curve shifts upwards. E remains unchanged. in the long run. Short run: Long run: additionally Increase in G  Increase in money supply Increase in prices and decrease in output. 1. Increase in G Goods market: Demand for domestic goods increases at given E. Money market: Real money demand increases due to increase in Y  R increases for equilibrium on the money market. Domestic money market: increase of supply of domestic currency decreases domestic interest rate (R decreases) for equilibrium on domestic money market. Without central bank intervention: Domestic currency appreciates (E decreases). AA–curve shifts downwards to initial position. Alternative 2 Considering domestic money market and foreign exchange market: 1. which decrease demand for domestic goods. Appreciation of domestic currency. Long run: when an increase in G is permanent: inflationary bias. However. buying domestic currency in exchange for foreign currency). On the money market. which increases demand for domestic deposits and for domestic currency.g. Fiscal policy with fixed exchange rates Short run: fiscal policy is more effective: due to fixed exchange rates. With central bank intervention: Central bank decreases supply of domestic currency (e. there is no crowding out of private demand due to an increase in public demand. 58 . 2. 1. 2. With central bank intervention: Increase in real money demand is compensated by an increase in domestic money supply  AA-curve shifts upwards  no increase in R and demand for domestic currency relative to foreign currency. DD-curve shifts to the left due to the increase in prices. Foreign exchange market: Increase in R increases demand for domestic deposits and domestic currency. Domestic interest rate increases (R increases). This happens under fixed exchange rates. This happens under flexible exchange rates. but the real exchange rate decreases: q$/€ = E$/€ x PEU/PUS Depreciation/appreciation: value of currency changes due to market forces. R increases  E decrease However. When reserves are used up. Central bank reduced domestic money supply further 2.E is constant. Devaluation: Higher fixed E Revaluation: Lower fixed E Currency devaluation 1. Increase in money demand without increase in money supply. Investors may expect further devaluation:  investors sell domestic assets and buy foreign assets  demand for domestic currency decreases  this accelerates the decrease of foreign exchange reserves of the central bank  domestic currency devaluates. Higher interest rate reduces demand for domestic goods  domestic output and employment decrease. 4. 3. Increase in E increases demand for domestic goods: output Y increases. Financial crises and capital flight Demand for domestic currency decreases  central bank constantly buys domestic currency in exchange for foreign currency to fix the exchange rate. increase in money supply decreases R and leaves R* unchanged: R decreases  E increases to a higher level. E increase and Ms increases 2. 59 . A higher domestic R is needed: 1. Capital flight: Financial capital moves out of the country Investments and demand for domestic goods decreases. Devaluation/revaluation: value of currency changes due to central bank intervention on the foreign exchange market. the domestic currency devaluates. monetary policy is not independent anymore. i. domestic currency is devalued. Investors’ expectations are influenced by: 1. Speculative attack: speculators expect that central bank’s foreign currency reserves are scarce. again at a favorable exchange rate. Investors change foreign currency back into domestic currency. 2. monetary policy cannot be used to keep interest rates low or to fight inflation.Expectations of foreign investors decrease demand for domestic assets and crucially contribute to financial crises. Expectations about development of demand for domestic goods (Decrease in Yd  increase in E). R – R* = (Ee – E) / E. Speculators exchange domestic currency into foreign currency at favorable exchange rate. Currency crisis Investors lose confidence in an economy: Investors sell domestic assets Excess supply and devaluation of domestic currency With a fixed exchange rate regime. Real wealth increases if prices are fixed in the short run. Expectations about the central bank’s foreign currency reserves. monetary policy is not independent with fixed E. Policies which influence domestic money market (change in R) influence foreign exchange market. When central bank’s reserves are used up.e. Imperfect asset substitutability 60 . there is a direct relationship between interest rates and exchange rate. Risk premium on government bonds: reducing government debt. An increase in ρ shifts interest parity condition to the right  depreciation of domestic currency due to lower demand for domestic assets. Lecture 19 – International Monetary System (Ch. since there is a fixed exchange rate. Alternatively. 19) Fixed exchange rate systems 1. 3. Default risk. war. differences between: Returns on regular stocks and on government bonds Returns on government bonds of different countries. How can the central bank or government influence the risk premium ρ? ρ depends on investment alternatives. a depreciation of a currency lowers (expected) returns from investments into that currency. expropriation. 61 . Objective of government: macroeconomic equilibrium Domestic equilibrium: output level which results at natural rate of unemployment.18. the risk that the loan will not be paid back and investors lose their money. Adjusted interest parity condition: R – R* = (Ee . Types of risk 1. Changes in exchange rate system can be explained by the trilemma of objectives 1. If international capital mobility holds: transactions costs = 0. 2. Risk premium of regular stocks: securing trade credits. External equilibrium: combination of output Y and exchange rate E which leads to a current account equilibrium.Bonds which are denominated in different currencies imply different risk levels (higher risk  investors demand a higher return). Countries can only reach two out of these three objectives. Exchange rate risk. Reserve currency system: fixed exchange rate between domestic currency and foreign reserve currency. Monetary policy independence – adjusting monetary policy to economic conditions. Net effect: E remains constant. 2. central bank changes money supply and adjusts ρ to keep E constant Ms increases  R decreases  E increases Central bank simultaneously decreases risk of investing in domestic assets (ρ)  interest parity condition curve shifts to the left  E decreases.E) / E + ρ ρ: risk premium for investing in domestic assets (increase in ρ increases R). Gold Standard: value of currency is linked to value of gold (implied fixed exchange rate). Adjusted interest parity condition: R – R* = (Ee – E) / E + transaction costs. controlling exchange rate. 2. International capital mobility – allows to invest into the internationally most profitable projects. Fixed exchange rate – more transparency in international transactions. Either internal or external equilibrium is reachable. External equilibrium + . Only one instrument (G)  only one objective achievable. E) Y-axis: E X-axis: G↑. because increase in E (more private demand for domestic goods) has to be compensated by increase in G (Y↑. Positive slope. G. G0 / E0 leads to internal and external equilibrium. I. because a decrease in E (less private demand for domestic goods) has to be compensated by increase in G to keep employment/inflation constant. Above curve: CA surplus Below curve: CA deficit.+ CA = CA(G. T↓  Downward-sloping line that reflects domestic equilibrium.++ + Y = Y(C. Above curve: higher inflation / overemployment. Negative slope. Tinbergen Rule: A government can only achieve any number of policy objectives if it has at least the same number of independent policy instruments available.Domestic equilibrium + . T↓  Upward-sloping line that reflects external equilibrium. T. T. Increase (decrease) of G can reduce unemployment (current account deficit). Below curve: unemployment. E) Y-axis: E X-axis: G↑. which increases private demand for foreign goods) to keep trade balanced. not both. Fixed exchange rate: adjustment problems. 62 . macroeconomic equilibrium is not reachable if E is not equal to E0. breakdown of Bretton Woods system. otherwise deflation and unemployment. Bretton Woods Era (1945-1971) Establishment of International Monetary Fund (IMF) and World Bank New system of international economic order: Free trade No ‘beggar-thy-neighbor’ policies Stable international monetary system to encourage free trade. US dollar as international reserve currency (value fixed to gold price). No monetary policy available to fight unemployment. Disadvantages 1. 3. Great Depression 1929 – devaluations and capital controls in order to support domestic economy. Gold Standard (1870-1914) (Implied) fixed exchange rate regime.However. Consequences: aggravation of crisis. US had complete monetary policy independence. 4. there are also problems with flexible exchange rate – into which direction should the government start. Discoveries of new gold sources: Ms increases  inflation 2. Other currencies pegged their currency to the USD with ±1% margin. Consequence: other currencies had to be revalued with approval of IMF – break down of the Bretton Woods system. 63 . Floating exchange rates (1971-now) Exchange rates are not freely determined by market forces. An economy can only achieve both equilibria if the government first realizes domestic equilibrium and then external equilibrium. Growing economies require increase in central bank’s gold reserves. World wars and recession (1914-1945) Countries printed more money to finance the war – no convertibility into gold anymore. The other way around does not work. Speculation against USD by German central bank. outbreak of World War II. No separate legal tender (formal dollarization or euroization). High inflation in the US – other countries had to buy USD. Reality: exchange rates fluctuated in narrow margins: shipping costs of gold. Change of margin only with IMF-approval. The n-1 problem The USD was the anchor currency: all countries pegged their currency to USD. Currencies valued in terms of gold. expect China and Eastern Block. Countries with large gold reserves can influence worldwide inflation. Enormous USD reserves of other countries. unemployment. Exchange Rate Mechanism (ERM): currencies allowed to fluctuate ± 2. Due to strict German fiscal and monetary policies. Potential benefits of the Euro Greater market integration (economic growth) due to common currency. Pegged exchange rates within horizontal bands Crawling peg: fixed exchange rate is adjusted periodically. Managed floating: central bank influences exchange rate without commitment to a specific exchange rate. Greater flexibility with monetary policy Preventing speculation. implemented in 1992) Free movement of capital Coordination of policies Establishment of EMI/ECB Stability & growth pact – criteria for being allowed to participate in monetary union. capital flights.21) European Monetary System was originally a system of fixed exchange rates implemented in 1979. More uniform political interests. The EMS transformed into the European Monetary Union (EMU). so Great Britain had to leave the EMS. and Italy. Conventional fixed-peg arrangements. Credit system to help out countries that need assets and currencies to intervene in foreign exchange market. EMS member states adopted fiscal and monetary policies as Germany  inflation rates in the EMS converged. Crawling band: central exchange rate or margins of band are adjusted periodically. Spain. German influence moderated under European System of Central Banks (ESCB). No devaluations/revaluations. Independently floating: exchange rates determined by market forces. Membership of EMU implies exchange rate fixed within specific bands  restrained fiscal and monetary policies  Euro replaces domestic currency. Lecture 20 – International Financial Institutions (Ch. Maastricht Treaty (1991.25% around target exchange rates. whose currencies were allowed to fluctuate ± 6% around target exchange rates. there were some problems with the British pound.- - - Currency board arrangements: commitment to change domestic currency for specific foreign currency at fixed exchange rate. Britain. The ERM was redefined at a margin of ± 15%. and speculation with common currency. domestic currency issued only for foreign exchange at fixed exchange rate. Exceptions: Portugal. Convergence criteria 64 . 2nd alternative adjustment mechanism: transfer of additional tax revenues in the Netherlands to France. ECB + national central banks of EMU member states (Euro system). the goods prices depend on wages wNL and wFR. ESCB: 1.1. 2. overemployment in the Netherlands  workers could migrate from France to the Netherlands. used for unemployment benefits in France. A problem arises. EMU optimum currency area. 2. Public debt: (accumulated debt) less than 60% of GDP. depends on: Size of shock The less diversified the economy. Whether an adjustment is really necessary. In a monetary union. European countries are highly diversified – (real) exchange rate adjustment is less necessary. Therefore. Theory of optimum currency areas Advantage of monetary union in general: currency crisis can be avoided. However. EMS membership: no devaluation in the two years before entry into EMU. E is fixed. 65 .5 percentage points higher than average of three lowest inflation rates among EU member states. Demand and employment increase (decrease) in the Netherlands (France). However. However. Inflation: less than 1. 3. the more serious the effect of the shock. In case of symmetric shock: identical reaction by both countries only in case of homogeneous preferences. if EU had Wage flexibility (goods prices can adjust to the shock) Labor mobility (migration can cushion the shock) Large budget (monetary transfers can cushion the shock) Solidarity between countries (monetary transfers can cushion the shock) Diversified production structure (shock less severe) Homogeneous preferences (identical reaction to a shock). real exchange rate q has to be changed via changes in goods prices PNL and PFR. Budget deficit: (new debt) less than 3% of GDP. 1st alternative adjustment mechanism: unemployment in France. 5. because wages are inflexible in the Netherlands and France. labor mobility within Europe is small. 4. The goal is to keep inflation below 2% per year. National central banks of non-member states. Interest rate: less than 2 percentage points higher than long-term interest rate in average of three low-inflation countries. Suppose the following situation: Positive demand shock in the Netherlands. only feasible is EU budget were large and there would be a sufficient degree of solidarity. Negative demand shock in France. However. However. No reaction of exchange rates to changes in aggregate demand. EU countries outside EMU have not performed worse in last decade. Costs of having the Euro Exchange rates not determined by market forces. Benefits of common currency Elimination of transaction costs Price transparency: better arbitrage opportunities. more competition Less uncertainty with respect to foreign prices Less uncertainty with respect to future prices International currency: common currency can be reserve currency of other countries. Who pays for having artificially low/high exchange rate? Consumers (imports overly expensive) and workers (low real wages). but real wealth in creditor countries decreases. so EMY can still become an optimum currency area. Monetary integration leads to political integration. Higher inflation: real value of debt in debtor countries decreases. arguments in favor of Euro: Euro leads to more trade (less transaction costs) and more trade leads to more growth Appreciation of domestic currency increases price of domestic goods on world markets – less exports. Costs of common currency Loss of monetary policy independence for stabilizing output. there already was a fixed exchange rate regime. 66 . weak countries would benefit from flexible exchange rates. Large amount of foreign financial and direct investment. However. There is at least a high degree of economic integration: Large intra-EU trade. fixed at level of 1. Simple decision rule: A country should join currency area if benefits exceed costs of joining. Appreciation of domestic currency makes imports cheaper and forces domestic firms to become more productive. Before the introduction of the Euro. However: Size of intra-EU trade hasn’t increased relative to extra-EU trade. costs depend on degree of market integration. Importance of transaction costs is unclear. However. Most EMU countries benefit from common currency. a monetary union evolves over time. there is no empirical research on benefits of Euro. Seigniorage gains (difference between value of money and costs of issuing money) by central bank of currency union.